Individual Retirement Account, provided by some financial institutions or advisory services in the United States, which allows alternative investments for retirement savings or retirement planning.
Self-Directed Individual Retirement Account (SDIRA)
A self-directed Individual Retirement Account (SDIRA) is an IRA account that provides you with the flexibility to invest in a wide variety of assets outside the traditional options such as stocks, bonds, mutual funds, and ETFs available for investment through an Individual Retirement Account. SDIRA isn’t a new phenomenon — it has been around since 1974 in the tax code when IRA options were introduced. It allows for the same tax benefits available to Traditional or Roth IRA.
The reason people get attracted to SDIRA is the opportunity to invest in assets like real estate, cryptocurrencies such as Bitcoin, precious metals, loans, private companies. Considering alternative assets have provided good returns to some of the most sophisticated investors like pension funds and endowments, most investors look to SDIRA to improve their returns. The list of available options here is not exhaustive. The Internal Revenue Service (IRS) provides a list of investments that you cannot invest in instead of publishing a list of options available for investing. As per IRS guidelines, an investor cannot use SDIRA to invest in life insurance or collectibles. Here are some examples of collectibles:
- Metals — with exceptions for certain kinds of bullion
- Coins — (but there are exceptions for certain coins)
- Alcoholic beverages
- Certain other tangible personal property.
- Interestingly, even gold and other bullion are considered “collectibles”
under the IRA statutes and you cannot hold these in your SDIRA account
unless it is highly refined, bullion and in the physical possession of a
bank or an IRS-approved nonbank trustee.
The most common asset class in SDIRA is real estate as it’s probably the easier to follow provided enough research and due diligence has been done to select the right real estate portfolio. The one thing you have to keep in mind is not to breach the IRS self-dealing rule. Two examples of self-dealing are:
1. Don’t rent your own property
2. Engage a third party if the property needs repair or any other
work and don’t engage in fixing the property.
What happens if you breach this rule: the benefits of IRA will go away from the start of that year and if it’s a Traditional IRA, you will be subject to a 10% penalty.
Why should you bother investing in SDIRA?
- Diversification: Traditional IRA offers only stocks, bonds, mutual funds, ETFs and similar assets. You can get exposure to other assets like real estate, Bitcoin, private companies through SDIRA.
- Better returns: Although it’s hard to predict the returns of any asset class, most people get attracted to SDIRA to generate better returns as compared to those generated through publicly traded options available through IRAs.
- Investing in an asset class you have experience with If you know more
about an asset class than the average investor (for instance, cryptocurrency), it may not be a bad idea to allocate some of your retirement money to that portfolio.
What are the challenges?
- Limited providers: Household names don’t provide self-directed IRAoptions, therefore you need to do some research to find a custodian that suits your need. It is unlikely you will find one that offers you multiple assets (loans, real estate, private companies, cryptocurrency, etc.) under one roof.
- Liquidity: The account is meant to invest for the long term and for retirement but if there is a need for liquidity it may not be as easy as selling stocks, bonds or mutual funds in the public market. Most options available in self-directed IRA are not liquid and it will not be easy to convert them into cash immediately if there is a need.
- Risk: Higher the return, the higher the risk. If you invest in self-directed IRA, say in Bitcoin, the volatility of that asset class is currently higher than other asset classes and therefore although it has a potential for earning higher returns, the risk is higher too.
- Lack of information and higher cost: You need to do spend a considerable amount of time in performing due diligence to understand the ins and outs of the asset you are investing in. Usually, the cost
associated with opening SDIRA is higher compared to simple IRA accounts as well.
Considering the significant effort involved in investing in SDIRA, our recommendation is to proceed only if you are committed to taking the time
to understand the asset class you want to get exposure to through your
SDIRA account. Source: IRS
Feel free to use the comments section and we will be happy to answer any questions you may have.
That’s it from our end. Until next time!
Author: Sunil Gangwani, Co-Founder, Plootus